This invention relates to computer technology for optimizing portfolios of multiple participants and, in particular, for optimizing portfolios of fixed income instruments.
It is well known that computer technology can be effectively employed for financial applications. It is also known to employ computers that execute optimization programs, such as programs based on liner programming techniques, so as to achieve financial goals. For example, computer technology that analyzes and optimizes a portfolio held by a given entity is known. Computer systems have also been employed as an intermediary in transactions where multiple parties desire to trade specific equity instruments. In such computer applications, optimization may be employed to facilitate trading of an equity of interest. However, the inventors are not aware of computer technology developed for trading holdings of multiple participants, where a computer acting as an intermediary processes entire portfolios of the participating entities and generates trades that optimize portfolios for a desired result, particularly for portfolios of fixed income instruments.
Portfolio-based trading, for example, exists in the equities market, where investors may buy or sell a portfolio of stocks on an aggregate basis. The investor provides a statistical description of the portfolio, usually including how closely it tracks the SandP 500 index, the sector distribution of the portfolio, and a measure of the diversification of the portfolio. The broker then commits to trade the portfolio of unknown stocks for a fixed fee at the prevailing market price at a pre-arranged point in time, typically the market daily close. Because the broker only knows the xe2x80x9cstatisticalxe2x80x9d composition of the portfolio, the investor feels more comfortable that the broker is unable to affect the closing prices. Because of the statistical relationship between the portfolio and the index, the broker feels comfortable that the investor cannot unload a portfolio of unattractive securities. An important component of such a transaction is the independent price of equities contributed by the public transaction records of the equity markets.
The vast majority of fixed income transactions are performed on a principal basis where the broker takes the opposite side of the transaction from the investor. The lack of adequate fixed income transaction records and the broad range of structures and maturities of fixed income instruments creates a significant barrier to developing the confidence on either side of the transaction that pricing is fair. Thus, it is desirable to provide a system that employs unbiased pricing and reassures the investors that the transaction is a fair deal. Further, it is desirable to provide computer technology that supports such fixed income transactions and, in particular, enables multiple parties to participate in the transactions. In particular, it is desirable to develop computer technology that would allow multiple investors to specify constraints on their portfolio holdings and, within those constraints, allocate by the optimization computer process fixed income holdings to individual investors participating in the transaction.
As noted, in general, optimization techniques for financial applications are known. For example, Adamidou et al., Financial Optimization, S. A. Zenios, Ed., Cambridge University Press, Cambridge, 1993, describe the Prudential-Bache Optimal Portfolio System, based on linear optimization of security holdings. This system emphasizes xe2x80x9cscenario analysis,xe2x80x9d which involves the evaluation of stochastic price models over user views of volatility employing a linear programming optimization constrained by duration, convexity, and return of holdings.
Optimization methodologies relating to financial applications are surveyed in H. Dahl, A. Meeraus, and S. A. Zenios, Some Financial Optimization Models: I Risk Management, Financial Optimization, S. A. Zenios, Editor, Cambridge University Press, Cambridge, 1993; and in H. Dahl, A. Meeraus, and S. A. Zenios, Some Financial Optimization Models: II Financial Engineering, Financial Optimization, S. A. Zenios, Editor, Cambridge University Press, Cambridge. 1993. Linear programs are described for general immunization of liabilities with fixed-income securities and xe2x80x9cdedicationxe2x80x9d matching of assets to liabilities. The discussed programs become mixed-integer programs if round lots are to be traded. Mixed-integer programs are discussed for optimal settlement of financial forwards in a specific case of mortgage-backed securities and for optimal structuring of collateralized mortgage obligations.
Such publications on financial engineering do not teach computer technology that enables multi-party portfolio trading in fixed income instruments, wherein computer-driven optimization aids in rebalancing portfolios of multiple participants. Yet, there is a need for such technology. For example, there is a need to provide computer technology that enables multiple investors to recognize the economic benefits of selling bonds at a price below the price originally paid thereby obtaining a tax deduction. Accordingly, there is a need to develop technology that would enable investors to exchange portfolio holdings so as to substantially maximize the tax deductible loss. It is believed that technology for such portfolio trading between multiple parties that enables them to substantially optimize trades so as to substantially maximize tax advantages has not been developed by others.
Although the system and method of the present invention relates to computer technology applicable to a wide array of portfolio optimizations in trading among diverse parties, the preferred embodiment relates to a computer system and method that provide a capability of taking advantage of refunds on taxes paid within the previous three years by maximizing book losses on trades of multiple participants. The preferred embodiment provides technology that enables trades as swaps among multiple parties while keeping the trades out of the market. The advantage of swapping between portfolios of participating firms versus transacting in the open market is that large scale trades can be executed without adversely affecting the market trading. In addition, the specific preferred embodiment enables swap members to buy discount bonds as replacements, which may be problematic in the open market but provides further, two advantages.
The computer technology of the preferred embodiment facilitates a solution to a multi-party book-loss optimization. In general, the input to the computer system of the preferred embodiment comprises a set of bond portfolios owned by a group of firms, and the output comprises the set of trades which substantially maximizes the participant firms"" total book losses. The implementation of the preferred embodiment avoids churning (i.e., buying and selling the same security) and wash sales (i.e., buying and selling a sufficiently similar security) and, therefore, reduces a risk of degeneracy in the process of maximizing book losses.
In addition, individual firms typically have portfolio composition constraints that must remain satisfied in any intermediated transaction implemented by the system. Such constraints may include fixed market value of holdings within given sectors and maximum holdings of given names. The implementation of the preferred embodiment provides means for satisfying such constraints.
Although a particular implementation of the preferred embodiment relates to producing tax deductions, a person skilled in the art will realize that it can be generalized to allow different participants to have different objectives and still produce multi-party portfolio-based optimized transaction. Furthermore, as will be understood by a person skilled in the art, extensions are possible where the participants provide prices at which they would be willing to buy or sell rather than using uniform prices provided by the intermediary entity, as in the preferred embodiment. In general, a person skilled in the art will appreciate that the invention can be extended to accommodate differing views among the participants on the economic attributes of the fixed-income instruments in their portfolios.